Federal Bearings Co. v. Commissioner

FEDERAL BEARINGS CO., INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Federal Bearings Co. v. Commissioner Docket No. 9233. United States Board of Tax Appeals 9 B.T.A. 1063; 1928 BTA LEXIS 4304; January 6, 1928, Promulgated *4304 The actual cash value of intangibles paid in to the taxpayer corporation in exchange for shares of common stock determined. Carl Ehlermann, Esq., and George W. Smyth, Esq., for the petitioner. P. J. Rose, Esq., for the respondent. SMITH *1064 This is a proceeding for the redetermination of deficiencies in income and profits tax for the fiscal years ended January 31, 1919, January 31, 1920, and January 31, 1921, in the respective amounts of $19,428.27, $15,085.74, and $4,127.31. The question in issue is the actual cash value of intangibles paid in to the petitioner corporation for $750,000 par value common stock for the purpose of determining correct invested capital. FINDINGS OF FACT. From 1904 to 1910 Herman A. Schatz, his father and brother, John W. Schatz and Grover H. Schatz, owned and operated the Schatz Hardware Manufacturing Co., a corporation engaged in the manufacture and sale of ball bearings for commercial purposes, located at Chappaqua, N.Y. The bearings were of minor limits as to dimension, were not made with such accuracy as high-grade bearings used on highly organized mechanical equipment, and were used chiefly on*4305 juvenile vehicles, baby carriages, gravity rollers and kindred devices. In 1910 they formed a corporation known as the Schatz Manufacturing Co., under the laws of the State of New York, to take over the business of the Schatz Hardware Manufacturing Co. and the Acme Ball Bearing Co. The amount of cash capital invested in the Schatz Manufacturing Co. was $45,000. In 1912 Herman A. Schatz and his brother first began to turn their attention to the high-grade-bearing field. They first developed a high grade of commercial bearing. Ball bearings were usually of a cup and cone type and had to be adjusted in position so that the balls had freedom, and the Schatz brothers saw the need for a self-contained bearing. They developed and experimented along these lines and produced an annular ball bearing, self-contained, that could be sold at a moderate price, and entered that field which was open at the time. That was in 1912, and the development indicated the desirability of patenting not only the bearing itself but the method used in producing the bearings. The experiments conducted by the Schatz brothers in 1912 and 1913 convinced them that their high-grade bearings had exceedingly*4306 great possibilities because of ability to manufacture more economically due to the material and method employed. At that time ball bearings were being used in many different types of highly organized mechanisms such as machine tools, cotton-spinning machinery, different textile machines, pumps and motors. The automobile field, however, at that time offered the greatest possibilities because automobiles had so many moving members, and sales managers were making great claims for the ease with which their cars ran on account of the large number of ball bearings used therein. A fair *1065 average would be 12 to 13 bearings per car. The automobile business was making very rapid strides and offered untold possibilities in the sale of ball bearings. Herman A. Schatz had a thorough investigation made at that time of the patent situation relative to high-grade bearings, as to whether his company could manufacture under its new processes without infringing the so-called "Conrad" patents, under which practically all ball bearings were then manufactured. This investigation disclosed that under the Conrad patents the monopoly of the high-grade-bearing industry had been established; *4307 that the Conrad patents controlled the situation; that the Conrad licensees had established plants and refused to allow other concerns to enter the field. They had an absolute monopoly and dictated prices. Litigation had established that the licensees were the only ones who could manufacture a bearing having a continuous ring without any obstructions and thus dominated the art, and the Schatz brothers could not have broken into that field without developing noninfringing patents. The Conrad patents did not expire until 1923. Schatz consulted an eminent patent attorney and was advised that the inventions of himself and associates did not infringe the Conrad patents. Conrad patent 822723 covered a ball bearing where an outer and inner ring were employed, the problem being to get the balls between the two rings and keep them there without obstructing in any way the raceways that the balls ran on, because any obstruction of the raceways would seriously damage the bearing. Various methods had been tried. Under Conrad's method a ring is put inside of the outer ring and the ball is threaded in there. In order to retain the balls, he employed a separator and after he had put the*4308 balls in and pulled the ring down as far as possible, he applied the separator and left the balls separated. This gave an interior ring that had no obstructions whatever and the balls revolved perfectly and were left separated, by the separator. Herman A. Schatz attacked the problem in quite a different way. He placed the balls around the inner ring and had his outer ring divided into two sections. Consequently, when the inner ring is placed within the outer ring, the balls can be inserted and the two sections of the outer ring brought together. There are no obstructions in the inner or outer rings. Thus Schatz not only obtained the same advantages Conrad had, but his bearing was designed more directly than was Conrad's for use on automobiles and took up not only the radial thrust but also the annular thrust. In this way Schatz converted his ball bearing from a two to a three-point bearing and made a very meritorious change over what had been previously the adopted standard of bearings in the automobile game. *1066 The various patents acquired by the Schatz brothers upon high-grade ball bearings were applied for and issued as follows: Patent No. Date applied for Date issued 1073529 Sept. 7, 1912 Sept. 16, 1913 1073530 Mar. 12, 1913 Do. 1176169 Apr. 29, 1915 Mar. 21, 1916 1176170 do Do. 1176133 May 7, 1915 Do. 1301323 Sept. 21, 1918 Apr. 22, 1919 1301752 Jan. 10, 1918 Do. 1339672 June 21, 1919 May 11, 1920 *4309 The Schatz patents avoided the Conrad patents and enabled the Schatz Manufacturing Co. not only to manufacture high-grade ball bearings without the payment of royalties but also to manufacture at lower Cost. It was only through these patents that the Schatz Manufacturing Co. could enter the high-grade ball-bearing field. As the foregoing patent applications were filed, the Schatz Manufacturing Co. offered bearings made pursuant to these inventions, and from 1913 to 1915, inclusive, was also very actively engaged in producing and selling these bearings up to the capacity of its equipment, but this was to prove the product and satisfy the trade of the merit of the high-grade bearings manufactured, and not with the idea of the Schatz Manufacturing Co. being big enough or strong enough to enter the field actively. During the years 1913 to 1915 the Schatz Manufacturing Co. entered into contracts to manufacture ball bearings under its inventions, totaling $184,693, and filled at least 75 per cent of these orders. These customers in most instances continued as customers of the Federal Bearings Co., Inc., when formed. During the same period Herman A. Schatz conducted experiments*4310 and made cost analyses which would indicate the difference between the cost of production under the company's inventions as against the other methods with the equipment available at that time and proved that the cost of production was reduced by some 25 per cent to 40 per cent. In 1914 it became apparent that in order to take advantage of the great opportunity afforded the patentees of the Schatz inventions to enter the high-grade ball-bearing field, Herman A. Schatz and his associates would have to form a new corporation with a larger capital, which would devote itself to high-grade ball-bearing production. Accordingly, the petitioner was formed under the laws of the State of New York, in December, 1915, with an authorized capital of $250,000, preferred, and $750,000, common stock, par value of each share $100, for the sole and exclusive purpose of manufacturing high-grade ball bearings under the five patents above mentioned, theretofore *1067 granted or applied for and specifically referred to in the certificate of incorporation. The petitioner received an offer in writing from the Schatz brothers of an exclusive license to manufacture, use and sell "full ground" bearings*4311 under the five letters patent above mentioned, issued or applied for, in consideration of the issuance and delivery to them of $750,000 par value of authorized common stock of the petitioner and $50,000 in cash or securities acceptable to them. The offer was duly accepted by resolution of the incorporators at a meeting held December 21, 1915. The resolution recites that the incorporators consider the exclusive license offered them reasonably worth the consideration asked. The offer above referred to was duly accepted at a meeting of the board of directors of petitioner corporation, held December 22, 1915. Said license agreement was duly executed on December 22, 1915. It covers the United States and all foreign countries and the five patents and applications therefor referred to, and all later improvements made by any of the three Schatz brothers in full-ground bearings. It forms the foundation of the business of the petitioner, which has always been engaged exclusively in the manufacture of bearings pursuant to said patents and a few later ones which merely constituted improvements. Everything in and about the business is dominated by the patents. The preferred stock*4312 in the amount of $250,000 par value was underwritten by E. Gray Parrott and Howard F. Butler of Boston, under date of March 1, 1915. They agreed to take the entire issue, to be paid for in cash, one-fourth to be paid not later than April 30, 1916, one-fourth by May 31, 1916, one-fourth by June 30, 1916, and the balance by July 31, 1916. This agreement was carried out. The underwriters made a thorough investigation to ascertain the value of the patents. They considered the profits made by the Schatz Manufacturing Co. in high-grade ball bearings and the fact that these patents gave entree to a field of business amounting from fifty to sixty million dollars per year, up to then a monopolized field. It was their judgment that the patents were very valuable and worth a great deal more than $250,000, and they were convinced that the payment of $250,000 cash for the preferred stock, to provide plant and equipment for the company's business, was a good investment. The preferred stock of the petitioner was entitled to cumulative dividends of 7 per cent a year, and in case of liquidation or other winding up, was entitled to par and accrued dividends. The preferred dividends were guaranteed*4313 by the Schatz Manufacturing Co. *1068 The preferred stock was sold to the public at par with a bonus of 25 per cent of common stock. The common stock given as a bonus was donated by the assignees of the patents, to whom the common stock was issued for the license to manufacture under the patents. Out of the proceeds from the sale of the preferred stock the $50,000 cash due to be paid to the patentees in pursuance of the agreement whereby the patentees assigned their rights in the patents to the petitioner was to be paid. During the year 1916 there was paid to Schatz brothers, assignees of the patents, the sum of $41,250. The balance of the $50,000 was paid to Schatz brothers in preferred stock. In or about August, 1916, the Schatz brothers were offered $50 per share for a controlling interest in the common stock of the petitioner. The offer was refused, the Schatz brothers being of the opinion that the stock was worth a great deal more than that. A few sales of the common stock were made during the latter part of 1916 at prices between $50 and $65 per share. The net profits and gross sales of the petitioner for the fiscal years ended January 31, 1917, to January 31, 1926, inclusive, *4314 were as follows: Fiscal year ended Jan. 31 - Gross sales Net profits — 1917 — $6,743.57 — 1918 — $222,310.25 39,668.91 — 1919 — 318,141.02 34,373.06 — 1920 — 472,206.62 88,491.04 — 1921 — 625,766.86 32,692.60 — 1922 — $624,592.68 $33,439.19 — 1923 — 755,675.14 129,673.05 — 1924 — 1,040,080.16 149,301.31 — 1925 — 992,997.58 154,976.76 — 1926 — 315,786.56 OPINION. SMITH: At the hearing of this proceeding question was raised by the respondent as to the jurisdiction of the Board so far as it related to a deficiency determined for the year ended January 31, 1919. The basis for the argument was that the tax had been assessed and that the respondent had not determined a deficiency for the period, within the meaning of the Revenue Act of 1926. In his brief, respondent admits the jurisdiction of the Board to entertain the proceeding for the three years ending January 31, 1919, January 31, 1920, and January 31, 1921. The pleadings in this case raise three issues, as follows: (1) Whether the petitioner is entitled to $250,000 in its invested capital for the fiscal years ended January 31, 1919, January 31, 1920, and January 31, 1921, on account of intangible assets acquired*4315 at time of incorporation in 1915, for stock; (2) Whether the reduction in invested capital for 1920 and 1921 has been overstated by the Commissioner on account of the disallowance of at least $250,000 in invested capital for the immediately preceding year; *1069 (3) Whether the respondent has overstated the deduction for inadmissibles in the amount of $20,331 for the year 1920. The determination of the first issue will dispose of the second and no further reference will be made thereto. No testimony was taken nor any proof offered relative to the third issue and the respondent's motion for judgment with respect to that issue is granted. The petitioner contends that the value of the intangibles paid in to the corporation in exchange for $750,000 par value of its common stock had an actual cash value of at least $400,000. In support of its claim it has submitted a mass of evidence as to the situation which existed with respect to the manufacture of high-grade ball bearings during the period 1912 to the present time. The officers of the company were not desirous of selling the patent rights and getting out of the field of the manufacture of high-grade ball bearings. *4316 They were of the opinion that they could make the business a great success. They therefore refused to sell a controlling interest in their common stock in 1916, shortly after the petitioner was incorporated and before it got into production, at a price of $50 per share. At the time they held in excess of 60 per cent of the stock. We are of the opinion that this proves that the intangibles paid in to the corporation for the common stock had a very great value. In addition to all of these proofs of value expert testimony was offered as to the value of the patents. A patent attorney of wide experience in 1927 computed their value on the basis of amounts earned by the Schatz Manufacturing Co. in 1914 and 1915, and the growth of the automobile business as it could reasonably have been foreseen by the end of 1915. He concluded that the value of the patents at that time was between $400,000 and $500,000. In Nice Ball Bearing Co.,5 B.T.A. 484, 496, we stated: The value of patents at any given date is, like the value of other property, a question of fact which must be determined upon the evidence. *4317 In the appeals of Dwight & Lloyd Sintering Co.,1 B.T.A. 179; Gamon Meter Co.,1 B.T.A. 1124; and J. J. Gray, Jr.,2 B.T.A. 672, the Board has laid down the rule that in determining the value of patents at any basic date it would take into consideration the history and the volume of profits produced by the use of the patents, the opinion testimony of men experienced in dealings in patents and in the products protected by the patent monopoly and would also consider the subsequent history of such patents, together with the volume of profits produced by their use in business, and upon the basis of such evidence determine the value at the basic date. From a consideration of all the testimony in this case we are satisfied that the actual cash value of the intangibles paid in to the petitioner corporation in December, 1915, for $750,000 par value of *1070 common stock was at least $250,000, the greatest amount which it can legally include in invested capital. Judgment will be entered on 15 days' notice, under Rule 50. Considered by TRUSSELL, LOVE, and LITTLETON.